THE BASICS (1) Flashcards
economics
the social science studying how to satisfies people’s unlimited wants with scarce resources - examines the production, distribution and consumption of goods and services and how to maximise welfare.
normative vs positive approach
normative = how should be done
positive approach - how things are done
finance
subset of economics, how to allocate resources over time and under uncertainty
risk
by definition, the future is uncertain
mean-variance model - modern portfolio theory
risk juxtaposed to return
CAPM
capital asset pricing model, what is a theoretically appropriate required return to an asset when added to a well-diversified portfolio.
asset pricing
valuing assets (value of securities)
corporate finance
how firms get funding and how they invest it
household finance
saving/investment decisions made by households
macrofinance
link between asset prices and economic fluctuations
market microstructure
price formation in asset markets
mathematical finance
novel methods and models to analyse financial problems
climate finance
incentives to mitigate/adapt to climate change and carbon pricing
behavioural finance
how psychological influences and biases affect financial decisions
Assumptions in finance
selfish agents, high returns better, low risk better, money now better than money later, security prices make supply = demand, financial innovation focuses on risk sharing and friction reduction, too many variables - models will be unrealistic
real asset
produce goods and services, generate net income to the economy and determine material wealth
financial assets
claims on real assets and hence on the income provided by the latter, each financial asset = financial liability, sums to 0. defines individual income/wealth amongst investors
net national wealth
sum of total real assets only
non financial firms
typically net borrowers, issue securities to investors and use funds to invest in risky projects, the funds can come from profit, banks, private equity, venture capital, private capital, stock market (public company), bond market(large firms)
households
net savers, purchase securities from government and non-financial firms and or depoist in financial firms /banks
government
NET borrower, through issuing bonds when taxes fall short - budget deficit sometimes saves = budget surplus
financial intermediaries
issue own securities to invest in financial assets, act as clearing houses for financial assets and liabilities bringing brorowres and savers together
overseas sector
borrow from overseas when domestic savings < domestic investment = capital account surplus
high liquidity
need to be easy to get back, small amounts low risk
low liquidity
e.g. infrastructure projects, years to get back, high risk
functions of financial intermediaries
size transformation - aggregation of small lenders and borrowers, maturity transformation - pool short term deposits to lend longer term - credit crunch risk (when everyone wants money back at same time and cannot liquidate fast enough) , risk transformation - smooth risk of lending to risky ventuires by pooling, diversifying,monitoring and hedging
financial markets in the economy
information role -setting security prices, allocate capital between uses, sep ownership and control, governance and ethics
timing of consumption - financial assets allow shift consumption to real good when earn more to earn less
risk allocation - allow risk to be traded across economy
what do financial markets achieve
efficient resource allocation (not necessarily optimal)
key features of financial markets - primary vs secondary
initial floating of security vs trade of already existing securities on a primary market
key features of financial markets - regulated vs alternative exchanges
e.g. stock changes vs more loosely regulated over the counter trading
order driven trading
all trades visible to everyone centralised and direct
quote - driven trading
decentralised intermediate, dealership can see what is being offered - less transparent but high reward
bid
price as which market maker is willing to buy
ask
price at which market make is willing to sell
bid < ask
liquidity
ability to trade a security fast at price close to fundamental value
depth
maximum order size that can be executed without affecting security price `
brokers
find buyer/seller counterparty
earn comission
dealers
counterparties for buyers and sellers,
earn bid/ask spread
exchanges
automated - no need for brokers + dealers
equity market
flow of funds
bonds
intruments constituting a loan made by buyer (lender) to issuer (borrower)
fixed - income
bonds - loan today
purchase price (usually below face value)
bonds - coupons
interest payments
bonds - principle/face value
payment due back at maturity
government bonds
semi-annual coupons (collected every 6 months)
normally considered riskfree
interest rate contingent on maturity
treasuries, gilts (coupons adjusted for inflation)
corporate bonds
different repayment priorities
higher yield than government bonds
variation in risk
yield
interest rate that makes current price fair
stocks
ownership of a share in a business, entitles shareholders to dividendsva
value of of stocks
present value of future dividends and liquidation value or expected present value of future cashflows frmo business projects after paying off creditors
debt
not an ownership interest, creditors do not have voting rights
interest is considered the cost of doing business and tax is deductible
creditors have legal recourse if interest or principle payments are missed, FUTURE CASHFLOW IS OFTEN KNOWN
excess debt
financial distress, bankrupty, agency debt issues
equity
ownership interest, common stockholders vote for board of directors and other issues, dividends are not considered cost of doing business and are not tax deductible, dividends are not a liability to the firm and stockholders have no legal recourse if dividends are not paid
all equity firm cannot go bankrupt and FUTURE CASHFLOW IS STOCHASTIC
EQUITY INDICES
Dow Jones - price weight
Standard and Poors - value weighted
FTSE 100 - value weighted
futures
contractual agreement to exchange a security for a specified cashflow on a future date
swaps
a contractual agreement to exchnage two sets of cashflows over a specified time period
forwards
Non standardised contracts to exchange a security for a specified amount on a future date
convertibles
debt instruments that convert into company equity under certain condition
options
instruments that give one party the right to buy or sell the underlying security
asset-backed securities
instruments collateralised by an underlying pool of assets such as mortgages, receivables, life insurance policies and loans
cash funded transactions
through bank account/cheque
margin funded (bull)
more funds -> risk of losses and value fluctuations could lead to forced sales - have to provide at least 50% - buying from a broker and maintenance margin at least 30%.
margin =( value of security - loan) / value of security = equity/value of security
security prices expected to rise by investor
short selling (bear)
With short selling, a seller opens a short position by borrowing shares, usually from a broker-dealer, hoping to buy them back for a profit if the price declines. To close a short position, a trader repurchases the shares—hopefully at a price less than they borrowed the asset—and returns them to the lender or broker
inverstor expects security prives to fall
equity
ownership interest in a company
